Monday, September 26, 2011

More Than One Inflation Rate

Often consumer price inflation is described as being just one for everyone. While that is a correct assumption in some contexts, it is misleading in terms of analyzing the effects for different groups-and individuals.

For example, if prices on alcohol and tobacco rises substantially, then people who are both teetotallers and non-smokers will see no reduction in purchasing power at all, while people who are heavy drinkers and/or smokers will see a significant reduction in purchasing power.

Similarly, if prices of luxury goods rises, then that will have almost no effect on the purchasing power of the poor while significantly reducing the purchasing power of the rich, while higher prices on cheaper forms of food or clothes will have almost no effect on the purchasing power of the rich while significantly reducing the purchasing power of the poor.

Sometimes the rich spend more money on certain items, like food, clothes and fuel, yet people with low income might still be hit harder from rising prices of the commodities used, because first of all their income is by definition lower and the spending on these items may therefore still be a higher percentage of their total spending, and secondly because they to a higher extent buy food and clothes whose production costs to a higher extent consists of commodity inputs.

Most statistical bureaus around the world either are unaware of or ignores this insight, but Hong Kong's statistical authority has interestingly created, besides the general CPI, three sub-indexes for people with low income (called CPI-A), middle income (called CPI-B) and high income* (called CPI-C) earners. In the latest year, despite having a higher food price inflation, low income earners have had somewhat lower inflation rate than middle income earners, with middle income earners similarly having a somewhat lower inflation rate than high income earners despite having higher food price inflation.

4 Comments:

Hi, I' curious about how inflation spreads through the capital structure of the economy.

First of all, commodities seem to be first kind of goods to be affected by (expectations of) increased money supply, is that generally true? I wonder if this is because commodities are similiar to money in that they are homogenous and easily exchanged? Also, raw materials have many ways of being processed into consumer goods and therefor specific knowledge about complementary capital is not so important.

I would then suppose that inflation spreads from commodity prices to prices of capital (equipment) which is used by commodity producers. Some commodities are extracted raw material, like raw oil. Others are outputs of a few refining step (like vegetable oil). Capital goods inputs to such mines, farms and refinaries, and the stock prices of companies owning them, should increase in response to increased commodity prices.

Thereafter it gets more complicated. Industries using refined oil products see higher costs, but does this mean that their output goods prices (and their input capital equipment prices) increase or decrease?

Further down the production processes in the capital structure, the inflationary effects should become less direct. Prices of goods and capital equipment used for especially in service sectors, should be the ones affected last and to the least degree of the inital monetary inflation, since they have the largest labour and intermediate technology cost component.

Could an analysis of such kind be economically interesting, or is it misconcieved? Maybe stock indexes should be sectorized by how far from commodities companies are located in the capital structure and production chains? Food is close to commodities, lawyers are far away and that should say something about their susceptibility to inflation.

Hi, I' curious about how inflation spreads through the capital structure of the economy.

“First of all, commodities seem to be first kind of goods to be affected by (expectations of) increased money supply, is that generally true?”

Yes

“ I wonder if this is because commodities are similiar to money in that they are homogenous and easily exchanged?”

There are several reasons, one important reason is that their prices are the most flexible, being priced on financial markets.

Another important reason is that most commodities are far away in terms of time from final production, meaning that they are more sensitive to changes in real interest rates, and rreal interest rates falls when there is monetary inflation.

“I would then suppose that inflation spreads from commodity prices to prices of capital (equipment) which is used by commodity producers. Some commodities are extracted raw material, like raw oil. Others are outputs of a few refining step (like vegetable oil). Capital goods inputs to such mines, farms and refinaries, and the stock prices of companies owning them, should increase in response to increased commodity prices.”

Well, yes.

“Thereafter it gets more complicated. Industries using refined oil products see higher costs, but does this mean that their output goods prices (and their input capital equipment prices) increase or decrease?”

They increase as their production costs increase.

“Further down the production processes in the capital structure, the inflationary effects should become less direct. Prices of goods and capital equipment used for especially in service sectors, should be the ones affected last and to the least degree of the inital monetary inflation, since they have the largest labour and intermediate technology cost component.”

Correct.

“Could an analysis of such kind be economically interesting, or is it misconcieved? Maybe stock indexes should be sectorized by how far from commodities companies are located in the capital structure and production chains? Food is close to commodities, lawyers are far away and that should say something about their susceptibility to inflation. “

Such an analysis is indeed interesting and have in fact been made by several “Austrian” economists.

Thank you for your feedback! I want to ask about the separation of the concepts of time-to-consumption and the fraction-of-commodity-content of a good.

I've seen Hayek's reasoning which illustrates the production process like a triangle of increasing value over time. The interest rate of course has a straight forward effect on price level over time to consumption.

But I wonder if not the fraction of the price of each (intermediate) good (and hence the price of the capital equipment used to produce it), which consists of commodity prices, is an even more important factor for inflation susceptibility of that specific good. A consumption good which sells for 100 and which is made out of commodities bought for 80 (like electricity from natural gas), should be more sensitive to inflation, than a consumption good which has commodity inputs which account for only 20% of its sales price (like a car out of iron and rubber etc). Even though both are consumption goods. The difference is a matter of "structural" distance to (money-similar) raw materials, rather than "time" distance to consumption.

The time length of production processes have been drastically shortened the last decades (thanks to concepts like JIT), and so the effect of interest rate on the difference of inflation sensitivity between raw materials and consumer goods, should have decreased in the same degree. But the part of inflation dependence which is caused by the fraction of commodity should have remained.

The inflation due to time-to-consumption, depends on the money inflation's effect on interest rate.

The fraction of the consumer goods value which consists of money-similar-commodity inputs, however, does not depend on the interest rate or time-to-consumption.

I wonder if such a money-similarity concept of how inflation spreads throughout the capital structure, is viable. It would be based on the assumption that people exchange money for "liquid" commodities (semi-money) when they expect increased money supply.

Most of all, I wonder if price speculation based on inflation through the capital structure is feasible...

“But I wonder if not the fraction of the price of each (intermediate) good (and hence the price of the capital equipment used to produce it), which consists of commodity prices, is an even more important factor for inflation susceptibility of that specific good. A consumption good which sells for 100 and which is made out of commodities bought for 80 (like electricity from natural gas), should be more sensitive to inflation, than a consumption good which has commodity inputs which account for only 20% of its sales price (like a car out of iron and rubber etc).”

Yes, because part of the higher inflation sensitivity is the more flexible pricing of commodities.

“The time length of production processes have been drastically shortened the last decades (thanks to concepts like JIT), and so the effect of interest rate on the difference of inflation sensitivity between raw materials and consumer goods, should have decreased in the same degree. “

Well, I don't think the shortening has been “drastic” as it still takes a lot of time to for example extract oil from the ground, but some shortening has probably taken place.

“But the part of inflation dependence which is caused by the fraction of commodity should have remained.”

No, because as I said the commodity sensitivity is in part a function of the time factor.

“I wonder if such a money-similarity concept of how inflation spreads throughout the capital structure, is viable. It would be based on the assumption that people exchange money for "liquid" commodities (semi-money) when they expect increased money supply.”

Well, people do buy gold and some other durable commodities as inflation hedges.

“Most of all, I wonder if price speculation based on inflation through the capital structure is feasible..”

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